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Thursday, June 6, 2013

The IMF's review of its role in the 2010 Greek bailout

The WSJ, NYT and others have run stories about an internal review prepared by the IMF staff of the IMF's role in the Greek bailout of 2010.  Both the WSJ and NYT manage to work into the lead paragraph of their stories the implication that the report criticizes the imposition of so-called "austerity" on the Greek people.  The Times' first paragraph calls the report "the latest in a series of partial mea culpas as the fund reassesses the austerity that it has insisted on for ailing, debt-plagued economies."  The Journal's second sentence likewise claims that the IMF "badly underestimated the damage that its prescriptions of austerity would do to Greece's economy, which has been mired in recession for the last six years."  So a casual reader might think that the IMF report is an indictment of so-called austerity and in the future the IMF will instead ratify ongoing levels of  government outlays.

Having read the report,, I think that would be a very inaccurate interpretation of it.  The report devotes only a tiny fraction of its content to anything that might be labeled  "austerity" (a word they conspicuoulsy avoid using) and to the extent it takes on the topic of fiscal adjustment,  the staff clearly concludes it was necessary and unavoidable.  Any modifications they might prefer to have seen are clearly minor tweaks of design, and not a repudiation of fiscal disclipine.  Paragraph 67 states this most clearly:

"67. The report does not question the overall thrust of policies adopted under the SBA supported program. . Fiscal adjustment was unavoidable, as was the sharp pace of deficit reduction given that official financing was already at the limit of political feasibility and debt restructuring was initially ruled out. Structural reforms were clearly essential to restoring competitiveness. Some questions can be raised about the types of measures (overly reliant on tax increases) and structural conditionality (too detailed in the fiscal area), but the policies adopted under the program appear to have been  broadly correct. [Boldface in original]."

Moreover, they clearly blame government spending for Greece's predicament in the first place.  Paragraph 46 states that "the ballooning of the fiscal deficit in the 2000s was almost entirely due to increased expenditure".  Paragraphs 2 & 3 explain that in greater detail: "Adoption of the euro and loose global credit conditions in the 2000s allowed Greece easy access to foreign borrowing that
financed a significant expansion of government spending." After adopting the euro, "government interest expenditure dropped from 11½ percent of GDP in the mid-1990s to 5 percent of GDP in the mid-2000s. However, these savings were more than swallowed up by increased spending on wages and pensions."  In other words, the IMF is saying, in Greece, all the fiscal benefit from joining the euro was transferred to public sector employees.  The pension system was a particular cause of Greece's fiscal problems: "At 16 percent of GDP, pension spending in Greece was among the highest in the EU in 2010. Key pension indicators suggested a generous system: the replacement rate (pension-to-wages) was 57 percent, the third highest in EU; the dependency rate (pensioners-to-contributors) was 29 percent, above the EU average; the official retirement age was 60, well below the OECD average of 63.2, and the average pension (including all pensions) was very close in level to that of a typical German worker with full contribution history. Pension projections pointed to a solvency problem."

Paragraph 4 goes on to portray Greeks as using the benefits of the euro to boost their current consumption at the expense of investing in their future: "The counterpart to the decline in government saving was a sharply widening current account deficit [the excess of imports over exports] that reached 15 percent  of GDP in 2008. The sustained economic boom and a lack of competition in domestic goods  and services markets kept wage and price inflation consistently above euro averages.  Competitiveness, as measured by the unit labor cost (ULC) -based real effective exchange rate (REER), declined by 20-30 percent in the decade following euro adoption."
And how bad was the so-called "austerity"?  Paragraph 26 summarizes it as follows: "primary expenditure declined by 4 percentage points of GDP in 2009–11, but still exceeded the 2005 level by about the same amount. Moreover, the wage bill remained high compared with other EU
countries; programs for social protection remained largely untargeted and inefficient ...." [my emphasis].  The review instead implies, in paragraph 46, that the mix of fiscal discipline ought actually to have been more weighted toward reducing spending than it was: "As discussed earlier, the
ballooning of the fiscal deficit in the 2000s was almost entirely due to increased expenditure.  The large dose of revenue measures ... can thereore be questioned ...."  Paragraph 47: "plans to downsize the number of civil servants were limited to a commitment to replace only 20 percent of those who retired. The state enterprises also remained generously staffed."
Nor does the review advocate a slower pace of fiscal consolidation. Paragraph 38-40: "It is difficult to argue that adjustment should have been attempted more slowly."; and "While earlier adjustment of the targets could have tempered the contraction, the program would then have required additional financing" while noting the Greek bailout was already the largest in IMF history.  The staff also rejects the notion that the imposition of austerity caused the macroeconomic contraction: "Part of the contraction in activity was not directly related to the fiscal adjustment, but rather reflected the absence of a pick-up in private sector growth due to the boost to productivity and improvements in the investment climate that the program hoped would result from structural reforms. Confidence was also badly affected by domestic social and political turmoil and talk of a Greek exit from the euro by European policy-makers. " This is similar to what we saw in the US in 2008 and 2009, when the government's drastic intervention in many markets and companies caused many private sector actors to sit on their hands until things settled down and political risk subsided. The report's bottom line is that, while mistakes were made, the overall approach was "broadly correct" and the main problem with the Greek economy and polity; paragraphs 33 & 34 observe that the major labor markets, key producers and the regulatory environment all remained resistant to structural reforms, meaning that growth was stifled by key players in the Greek economy holding on to economic rents embedded in the existing political setup. 
In reporting on the report's analysis of the 2010 decision to not require a debt write-down at the time, although one became necessary in 2012, the articles also downplay the systemic risk that the report identifies in multiple places as a concern.  Both reports quote the review's characterization of the step as "politically difficult".in 2010, implying that the protection of private debt at the time was a "politically" motivated one.  This severely mischaracterizes the report, I believe.  Rather, the report emphasizes that there was extensive concern in 2010 that Greece could become "another Lehman" the disorderly default by which would have terrible spillover effects on the rest of the European and world economy by taking down numerous large financial intermediaries. Footnote 1: "The ECB argued that the financial integration associated with monetary union - a benefit during normal times – served to intensify systemic spillover effects during periods of stress."  Paragraph 14: "a high risk of international spillover effects provided an alternative justification for [the IMF to participate in a Greek bailout]".  Paragraph 42: "if Greece had defaulted, the absence of deficit financing would have required primary fiscal balance from the second half of 2010. This would have required an abrupt fiscal consolidation, and led to an evaporation of confidence and huge deposit outflow that would have most likely made the contraction in output even larger." So Paragraph 55 spells out the analysis that led the 2010 negotiations to take a debt restructuring off the table:

"In fact, debt restructuring had been considered by the parties to the negotiations but had been ruled out by the euro area. There are a number of reasons for this:

"Some Eurozone partners emphasized moral hazard arguments against restructuring. A rescue
package for Greece that incorporated debt restructuring would likely have difficulty being
approved, as would be necessary, by all the euro area parliaments. [This is the one that could be called "political"]
"Debt restructuring would directly hurt the balance sheets of Greek banks. This would imply a
call on the program’s financing that would exceed the amount set aside for bank
recapitalization under the HFSF. [Nothing political about that]

"Debt restructuring risked contagion to other members of the Eurozone and potentially
another Lehman-type event, yet the EFSF was not yet in place. European banks had large
holdings of Greek bonds – but also, and of more concern given the scale of their exposure,
had large holdings of the bonds of other European sovereigns that would drop in value were
Greek creditors to be bailed in. For the euro zone as a whole, there might be limited gain in
bailing in creditors who subsequently might themselves have to be bailed out. [This is the most important reason and certainly not political]"

I think that Greece was such a basket case in 2010 that there was nothing that could realistically have been done to either preserve creditors' claims at par or protect the Greek citizenry from a depression.  The Greek fisc ran a staggering cyclically-adjusted primary deficit of roughly 15% of GDP in 2009 [table p.15], meaning that they would have had to reduce spending or increase taxes by that much in 2010 even if they had chosen to default on all of their debt; plus, as noted, local banks held so much of that debt they would have been rendered insolvent by such a default, adversely impacting the nation's economy further. (A default that was discriminatory, and only impacted foreign creditors, would have made future access to external capital markets impossible for an extended time and possibly cost them their Eurozone membership; indeed, if the contagion feared had come to pass, Greece would have been a pariah in the developed world and dead in the water for a long time. As for leaving the euro, I am probably in a minority that thinks it might have been manageable, but not on short notice, and in any case, the impact on living standards from the devaluation that would have resulted would have been little different from what actually happened.)
The real problem with the multinational authorities' treatment of Greece lies not in what they did after the problem manifested itself, but in the banking regulations that incentivized foreign banks to finance such a basket case of an economy in the first place.  Basel II classified all soverign debt as risk-free, for purposes of determining how much capital a bank had to hold to support its holdings of sovereign debt.  So every bank was incentivized to evaluate sovereign debt on only one criterion - yield - instead of the sliding scale between yield and credit risk.  Greek 10-years were priced at 50 bps over German 10-years at the end of 2009, reflecting a ridiculous amount of demand for such obviously inferior paper.  Yet, at that low premium, a billion dollars of paper would produce $5 million extra income with identical regulatory capital treatment, a deal that obviously many banks found too sweet to pass up in a yield-chasing, yield-challenged world.  It is absolutely not a coincidence that the three categories of debt that were at the heart of the global financial crisis that began in 2007 were the three that Basel II most preferred:  mortgages, AAA securitizations and sovereign debt.  That should be the main takeaway, and it has nothing to do with "austerity".

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